Chapter 11 Global Cost and Availability of Capital. Chapter 11 Global Cost &amp; Availability of Capital. Learning Objectives Show how a firm headquartered in a country with an illiquid and segmented capital market achieves a lower global cost of and greater availability of capital

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Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market

A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital

This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market

A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets

Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

Where

ke = expected rate of return on equity

krf = risk free rate on bonds

km = expected rate of return on the market

β = coefficient of firm’s systematic risk

The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt

Maria Gonzalez, Trident’s CFO, believes that Trident has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations

Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices

In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic the market

In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets

Illustrative case of a Danish multinational that sought to internationalize its capital structure by accessing foreign capital markets

Novo Industri is a Danish industrial enzyme and pharmaceutical firm

In 1977 the management sought to tap in to other capital markets because the Danish market was illiquid and segmented causing Novo to incur a higher cost of capital than that of its international competitors

Before the offering over 50% of Novo’s shareholders had become foreign investors

On May 30, 1981 Novo listed in the NYSE and although it had lost 10% of its value in Copenhagen the previous day, the $61 million offering was a success and the share price quickly gained all its losses from the previous day

Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts indicating MNEs have a higher cost of capital.

And indications are that MNEs have a lower average cost of debt than domestic counterparts, indicating MNEs have a lower cost of capital.

The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.

Gaining access to global capital markets should allow a firm to lower its cost of capital. A firm can improve access to global capital markets by increasing the market liquidity of its shares and by escaping its home capital market

The costs and availability of capital is directly linked to the degree of market liquidity and segmentation. Firms having access to markets with high liquidity and low segmentation should have a lower cost of capital

A firm is able to increase its market liquidity by raising debt in the Euromarket, by selling issues in individual national markets and by tapping capital markets through foreign subsidiaries

This causes the marginal cost of capital to lower for a firm and it results in a firm’s ability to raise even more capital

A national capital market is segmented if the required rate of return on securities in that market differs from the required rate of return on securities of comparable return and risk that are traded in other national capital markets

If a firm is resident in a segmented capital market, it can still escape from this market by sourcing its debts and equity abroad. The result should be a lower marginal cost of capital, improved liquidity for its securities, and a larger capital budget

Whether or not MNEs have a lower cost of capital than their domestic counterparts depends on their optimal financial structures, systematic risk, availability of capital, and the level of optimal capital budget